Why Energy Matters

Over on the Automatic Earth, folks are still debating the points I iterated about how energy drives everything, including finance. That in this view, finance is reactive. The dominant view is that finance is driving our crisis and we can ignore energy until we can't.

For my position, I argued that energy and finance interact dynamically, but that energy provides the constraints as to what gets done in the physical world.

Ilargi says this is false. That energy doesn't drive our economy. At times it does, but right now, finance dictates events.

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One point I tend to give short shrift to in my arguments is the 'Eureka!' moment that led me to realize that everything happens in reaction to energy.

And that understanding is fairly simple, and very profound.

Given...
1. Almost all of the energy that we consume is either fossilized, or incoming solar energy.
2. We know pretty accurately, how many BTUs of energy we have available to us.
3. The quantity of available energy determines the limits of industry.

Now in the interest of keeping this short, I'm not going to discuss efficiency improvements as a means of regaining growth in a declining environment at length. Just consider that to keep growing, while feedstocks decrease, requires rapid and continuous improvement forever. Very quickly you get to the point where you need to do infinite work, with zero energy. Diminishing returns, very quickly ends this avenue of exploration.

4. Worldwide, oil production is in a 6% annual decline.
5. Gas and coal are increasing at barely 1% per annum.
6. The production of energy in aggregate is likely then to be in a 3%-4% decline.
7. The quantity of workers continues to grow.
8. Everything we do, all that we are is determined by energy flows. We eat, we work, we produce, we reproduce. All of it requires the consumption of energy.

So our entire world, our lives, our jobs, homes, economy, finance, all of it, is bound by the quantity of energy we have to power it.

Nothing in our lives takes place without consuming energy. Not even thinking.

Nothing in high finance takes place without the consumption of energy.

Everything we do in commerce is a competition to control or consume energy.

Every product is produced by consuming energy. The use of every product, requires the consumption of more energy.

If energy increases, then commerce can increase. If energy is flat, commerce remains flat. If energy declines, commerce must decline.

This isn't an opinion though, many people may think it is one. This is how thermodynamics looks when applied to commercial activities. This is actually a 19th century understanding of the world. That Nobel Prize winning chemist, Frederick Soddy understood this long ago.

And this is the 'Eureka!' thing that I figured out on my own, only to discover like many other exciting ideas, was old and worn before I was born. But this knowledge, pieced together, all of the stuff I learned in school, that didn't fit together. The things that seemed random and disconnected, suddenly had relationships.

And even better, it gave me a framework to do simple modeling from and to make predictions with.

Ilargi believes that our current energy production decline is determined by economics. The only problem with this is that enforced production declines (esp OPEC) typically follow supply gluts which drop the price of oil. I don't know what economics text book he's gotten his learning from, but I'm not aware of a school of thought that says that when prices rise, you should cut production to make less money.

Ilargi refuses to explain why producers are slowing production to make less money as prices keep going higher. I don't think he can explain it. He doesn't know why this is happening. But he can ignore it.

Then there's the little problem that there is broad consensus in the industry that most of the biggest fields are in decline. In this view producers are working harder and harder to backslide. This view fits the declining production / increasing price relationship we are seeing, and doesn't require the suspension of belief.

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Now this should be enough theory and evidence to support the notion that economies are bound by available energy, and that our energy supply is contracting.

So what does this mean? How does this prove the economy is reacting to energy flows?

The next thing to understand is that our economies depend on growth. Almost every business borrows money to power growth, then repays that that money with interest. Historically those that best use this model, are able to out compete their steady state or slower growth rivals.

In a zero sum economy, one company's growth is dependant on another company's contraction. We are taught even this simple concept in the theory of market share. If you want more market share, then someone else has to lose some market share.

In the energy bound economy, we go outside the market model to understand that expansion of one company means that the price of energy goes up, as it outbids others to get more energy.

If you consider that energy can come in the form of matter, you'll understand how far reaching this concept is. It's not just electricity to power the lights or turn lathes, operate computers etc... The product that is bought and sold is also produced by consuming energy and represents an embodied investment in energy. A steel mill isn't just trading the energy needed to power tools, it's also trading the energy that went into smelting the iron, and refining it into steel.

So in a fixed economy, the expansion of one company's business, drives up costs for everyone. As each jockeys for growth, those that succeed, do so by beating down the competition. But as they grow, they increase their own costs also.

In this struggle, companies often turn to loans to pay up front for the costs of growth. But in aggregate, if every company in a fixed market grows, then predictably, there will be a lot of defaults on the loans. If there is only one winner, then that company will be the only one with a chance to pay off the note.

Only in a situation where energy growth continues indefinitely, can everyone see continued growth, and use that growth to pay interest on loans.

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Now we're in a contracting energy bubble. The odds of growth for any company are very slim. The competition has to go bankrupt at a rate that exceeds the energy decline rate, in order to leave room for those that are left, to grow.

At some point, everyone in finance will catch on that all of their customers are having trouble making payments on their loans. So they'll stop making loans to those customers. Well that's gonna be almost all of them.

In the traditional banking sense, making loans is how you do business.

So what do you do? You must keep making loans, or you lose future revenue.

The government now, doesn't like the slowdown they are seeing across the board. States and municipalities are seeing erosion in their tax rolls.

Everyone wants growth to continue. The Federal Government wants to grow. The State and local governments want to grow. Politicians want to help, and they find innovative ways to stimulate growth.

The bankers say it's an erosion of trust. That they are afraid that their customers can't pay them back. Politicians change laws, and promise in public and private to back loans to stimulate lending and growth.

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The road to hell is paved...

So the banks know industry is going out, but real estate hasn't seen a bubble in a while. With government backing they start making loans willy nilly to drive up the market.

Further they get government complicity in unregulated many forms of financial transactions. Banks find still other ways to grow without making traditional loans. They sell that 80s invention, derivative contracts, to governments then, knowing
these will blow up. They take out insurance to cover the costs when they explode.

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Now the tightening energy constraints, certainly didn't make any particular event happen.

But it did force the banks to find creative avenues for growth, in a period when real growth was flat and beginning it's decline.

If the banks had not invented phony ways to produce profits from nothing, then they would've been forced to contract with the rest of the economy. There was no legitimate means for them to make increasing quantities of money from sound business practices, and this problem continues today. The only way to make profits is in Ponzi scheme style finances.

And our government knows this to be true. The regulators would rather govern fraud, than a complete economic meltdown.

Those banks still trying to compete with the Ponzi fraudsters will go bankrupt. Soon enough the Ponzi fraudsters themselves will be competing for ever increasing government assistance, to grow faster as the economy as a whole degrades.

In such a view, the fraudsters are self selecting. Their emergence is completely predictable. If they aren't fraudsters, then they are bankrupt or going bankrupt.

As these financial institutions grow in a declining economy, it becomes quite logical and rational that a two tiered economy would manifest.

The first would be the traditional banking and industrial economy. As this economy is in decline, it will slowly deflate, as interest and loans are repaid without new loans being made.

The second economy is the fraud driven banks and their interactios with the Fed, the Federal Government, and government supported industries. As this economy has the power to continually create money and paper over debts, it will keep growing. Defense industries and military agencies certainly fit in this economy.

But in aggregate the two economies will balance when it comes to energy. The two combined in energy consumption must remain at a negative growth rate, even though the fraud economy continues to grow.

This means that the traditional economy that produces jobs, must decline faster, to provide the energy and materials needed to keep the fraud economy growing.

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This view in my opinion, provides the needed understanding to see the interconnectedness of our physical view of the world with it's relationships between energy and matter, and that of the world of high finance. It provides a view of cause and effect that makes sense of events in differing partsof our economy. It also provides a rational framework for understanding the wheels of high finance, and why our leaders make the decisions they make.

Further, if this view is correct, then it doesn't say anything good about our future. The players in this drama don't have to understand the forces at work, to react to events in their lives. It's unlikely that they do see the bigger trends and the rules of nature at play.

So there's no chance that our policies will adapt to account for the changes in the physical world.

So these trends must continue. The players in charge will make them continue. And the logical progression leads to massive unemployment, with no hope of turning it around without dramatic changes in our government.

This view is only bolstered by independant analysis from some very bright people, looking at our economics issues from other perspectives.

In the next few years, I expect that world energy production will decline at faster rates. With that, we should see an increasing frequency in economic disruptions.

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And once again, I'm going to boldly make my prediction, that in May we'll see another economic dislocation. I base this on the fact that oil prices continue to rise and that realization is dawning that the economy is not getting better. We should have some really crappy numbers reported for the end of this quarter. By the middle of the next quarter, something is going to give.

Another round of bailouts will likely follow.

Of course, if Obama wanted to distract the public, he coudl start another televised invasion of a soveriegn nation.